The authors are the CEO and director of the financial consulting company Complex. The factors in this column may invest in securities or instruments, including those mentioned therein. The foregoing does not constitute investment advice or marketing, which takes into account the data and the special needs of each person
Last week, the central bank in the US slowed down the rate of interest rate increases, and raised it by another 0.25%, to a range of 4.5%-4.75%. After a 0.5% increase in December, and four consecutive increases of 0.75%, a lot of optimism was created in the markets, prematurely In our opinion, regarding the impending end of the interest rate hikes.
However, in order to analyze interest rate trends, inflation and the effects on them, it is necessary to focus on the labor market in the US, and in particular on changes in employee wages, which are a central consideration in the Fed’s decisions.
The employment report published on Friday illustrated this, and played the cards. The report presented an addition of 517,000 jobs in January, triple the forecasts and double the addition of 260,000 in December.
As a result, there are now 11 million job vacancies in the US, 1.9 for every unemployed person in the labor force, up from 10.4 million in November. The unemployment rate has fallen to 3.4%, a 53-year low. This means that the US economy, which grew at an annual rate of 2.9 % in the fourth quarter of 2022, continues to create jobs at a high rate even in the face of the wave of interest rate hikes, in sharp contrast to recession expectations.
The developments clash head-on with the markets’ expectations that the Fed will not raise interest rates above 5%, and will begin lowering interest rates towards the end of 2023. So far, the Fed’s statements regarding continuing interest rate hikes and not lowering them throughout 2023, in order not to risk a reversal of direction before the fall in inflation is established, have been seen as ” Unreliability”, and intended to “suppress sentiment”. This is to curb the rise in stock prices and the fall in bond yields, which create favorable financial conditions and a “sense of wealth” among the public, elements that contribute to inflation.
Salary increases at the center
In our estimation, due to the surprising data from the labor market, the markets will be forced to re-price the interest rate expectations, for two additional increases in March and May, to a range between 5.25%-5% and possibly as much as 5.5% in June.
The biggest challenge facing the Fed in predicting the direction of inflation is a growing gap between the moderation of inflation and wage increases, the increase in job creation and the drop in unemployment. Headline inflation fell from a peak of 9.1% in June to 6.5% in December, but is still far from the Fed’s 2% target.
Core inflation, the inflation index excluding food and energy, also fell to 4.4% in December compared to 5.2% in September. Moreover, measurement in the months of October-December only, shows an annual inflation rate of 2.9%, mainly in light of the drop in energy and commodity prices, after the opening of the bottlenecks in the supply chains.
At the same time, the surge in house rental prices in the US in the last two years, a component that makes up more than 30% of the index, has slowed down, but is still not fully reflected in inflation, as it is updated in the price index with a gap of six months, and is expected to support the continued decline in inflation in the coming months.
However, according to the Fed, even the combination of things is not expected to be enough to lower inflation to the target, due to the pressures arising from the labor market. The employment report illustrated that the well-publicized waves of layoffs in the technology and finance sectors do not have a significant impact, since they are relatively small, and skilled workers in them find alternative work relatively easily. On the other hand, labor-intensive sectors, based on small and medium-sized businesses, such as hotels and restaurants, still suffer from a shortage of workers, and continue to recruit at an increased rate.
This creates continuous pressures for wage increases for employees. The rate and pace of wage growth are the focus of the Fed’s attention, because they are a major factor in the cost of many services and products and affect the ability of workers to pay for goods and services, thus threatening to create an effect known as a “wage and price spiral,” fueling inflation. That’s why the Fed is currently focusing on an inflation index based on labor-intensive services that are particularly affected by wage increases, such as law, electricians and cosmetics, which rose last year by 4.1%.
Overall, in the fourth quarter there was a certain moderation in the growth of wage increases in the private sector, when the average hourly wage rose in January by 4.4% at an annual rate, down from 4.8% in December.
In a simplistic view, wage increases are close to the Fed’s long-term target, at a maximum of 4%, and do not threaten to create a wage-price spiral in the short term. However, the picture is much more complex.
The key point is that along with the wage increase, the change in labor productivity must also be taken into account. To illustrate, assuming that labor productivity improves on average over time by 2% per year (so that the unit cost of a product or service decreases accordingly), a wage increase of up to 4% will result in a net increase in prices of 2%, in accordance with the Fed’s target.
The bad news is that in 2022 there will be a 1.3% decrease in productivity, the sharpest since 1974, which combined with the wage increase results in an effective increase in labor costs of about 6%. That’s already a long way from the Fed’s goal. At the same time, the high inflation erodes the real annual salary of about 3%, and creates pressure for additional salary increases.
Conclusions for the interest rate path
The obvious conclusion is that it is not possible to analyze the direction of inflation and interest on the basis of “data in the headlines”, but it is necessary to dive into more in-depth data, which affect the wage indices and the cost of services and products derived from them.
In our opinion, in order for the Fed to be able to stop raising interest rates and start lowering them, several conditions must be met.
First, continued decline or stability in commodity and energy prices, factors beyond the Fed’s control. Their return to the rise, for example due to a geopolitical event, could restart the engines of inflation.
Second, the continuation of the trend of curbing house rental price increases in the US.
Third, a decrease in the number of new jobs created per month below 200 thousand for several consecutive months, which will lead to an increase in the unemployment rate to 4.5% and a decrease in growth. At the same time, a decrease in the weighted rate of the wage increase minus the change in labor productivity is necessary below 2%, consistently over time. These conditions are very far from being met today in the hot labor market, and with them also the expected interest rate cuts.